A coal truck being loaded at Peabody's North Antelope Rochelle Mine near Gillette, Wyo.
Pebody Energy

There are multiple signs of equilibrium returning to the industry. Producers are slowly shuttering high-cost coal mines, taking excess supply out of the market. Demand has picked up as some electric utilities switch back to coal from natural gas, reversing decisions made in 2012 when gas prices dropped below $2 per million British thermal units, versus $3.54 now.

Additional coal demand is coming from Japan and Germany, which are shunning nuclear power. And the need for electricity continues to grow in emerging markets such as China and India, where coal-fired plants are the cheapest source of electricity. "Demand continues to grow globally and in the U.S.," says Peabody's chairman and CEO, Gregory Boyce.

There is worldwide demand for roughly eight billion tonnes of coal annually. (A metric tonne is equal to about 1.1 ton, or short ton, the standard in the U.S..) In the next four years, he estimates, annual demand could increase by 1.2 billion tonnes. "A year from now, pricing is going to be higher than it is today," he says.

In the U.S. and Australia, Peabody mines the thermal coal used by utilities. Down Under, it also mines metallurgical coal, used in making steel. In addition, it has a trading operation. "Peabody is positioned well to gain from its Australian platform catering to emerging-market growth," says Seerat Sodhi, an equity analyst with QCI Asset Management, which owns the shares. In Asia's emerging markets, she notes, natural-gas prices are four to seven times the price in the U.S.

Sodhi expects Peabody's shares to trade up to $30 or $35, roughly doubling their current price as earnings recover.

The drop in coal prices has taken a toll on Peabody's earnings. Wall Street expects the company, based in St. Louis, to earn just 15 cents a share this year on $200 million of operating profit and $7.1 billion of revenue. That's down sharply from the $3.76 a share it earned in 2011, when prices were stronger. But analysts are betting the miner's business will improve; the consensus forecast is for 66 cents a share in 2014 and $1.41 in 2015.

QCI's Sodhi is more optimistic, targeting earnings of 18 cents a share this year and $1.02 in 2014. The stock trades for an extremely high 98 times her 2013 estimate, but the ideal time to buy cyclicals is when earnings are depressed and price/earnings multiples are lofty. When earnings are high and multiples are low, it is usually the peak of the cycle—and an opportune moment to sell.

Peabody's loss of coal revenue has been somewhat offset by cost-cutting. In the second-quarter earnings release, the company announced it will reduce its cost per ton in Australia to the mid-$70s from $80. In the U.S., it has shifted output to its most productive mines. It also said 2013 capital expenditures will be lowered by $100 million, to $350 million to $450 million. When the turn arrives, the mine operator could enjoy sharply improved margins.

IN THE LATEST QUARTER, Peabody generated about 70% of operating profit from U.S. operations. The thermal coal it mines in the Western U.S. has low sulfur content and costs less to produce than coal mined in some other areas of the country. Last year, Peabody's U.S. coal operations produced almost 193 million tons of thermal coal, primarily used by utilities. Some 75% of the company's worldwide sales by volume were to U.S. electricity generators.

As a result, Peabody's fortunes are affected by the weather and electricity demand, as well as the price of natural gas, coal's main rival as a fuel source. Due to a mild winter in some parts of the U.S. in 2011, utilities were left with bloated stockpiles of coal. A year later, when natural-gas prices plummeted, many utilities that could switch to gas did so, notes Katie Teller, an operations-research analyst at the U.S. Energy Information Administration (EIA). Coal once accounted for almost half the fuel used by U.S. utilities in 2005, but its contribution shrank to 37% in 2012.

The benchmark price for Appalachian thermal coal retreated from almost $83 per ton in early 2011 to the low $50s last year. It has bounced between the low $50s and low $60s since, recently sitting at $54, according to SNL Energy.

The market dynamics are again reversing, with natural-gas prices having risen above $3. They are expected to stabilize at or slightly above that level. The supply of natural gas is expected to be flat after increasing for a number of years, due to gains in drilling-rig efficiency, says the EIA's Teller. Those efficiency gains are now behind us.

COAL'S MARKET SHARE in the utility industry is expected to rebound to almost 40% this year. With coal inventories normalized, roughly 50 million short tons a year of incremental utility demand could kick in, starting in the fourth quarter, says John Bridges, a JPMorgan analyst. He has a Overweight rating on Peabody and a $24 stock-price target.

It will take a while for price improvements to bolster Peabody's bottom line in the U.S., where 70% to 80% of its production is committed and already priced for 2014. Price improvements will have a more immediate impact on profits at the company's Australian unit, whose prices aren't locked in. Every $10 increase in metallurgical coal prices translates into an additional $125 million of earnings before interest, taxes, depreciation, and amortization, according to the company.

Met coal prices have been bouncing near their lows of $135 per ton this summer. Prices were north of $300 in 2008, according to Jason Hayes, associate director of the American Coal Council.

Peabody's Aussie operation kicks in roughly a third of operating profit. The company purchased Australia-based Macarthur Coal in 2011 for $5 billion. The deal—done when coal prices were near a peak—has left Peabody with $6 billion of debt it has been paying down slowly.

Boyce says Peabody would like to reduce its debt by roughly $1 billion. The company is open to the sale of nonstrategic operations to do so.

The Australian operation kicked in $1.2 billion in earnings before interest and taxes in 2011. That could shrink to $353 million this year, according to a BMO report. But when prices recover, the Australian business will be more attractive, given its exports to Asia. Peabody notes that, through June, China's net metallurgical and thermal coal imports were up a combined 15% compared with the like 2012 span, based on data published by China. This means imports are on pace to top last year's record high.

THE IMPACT OF ASIA and emerging markets on demand for energy can't be understated. The U.S. Energy Information Administration estimates that world energy use will rise by 56% from 2010 to 2040, largely due to China and India. While the agency sees coal's percentage of the energy market shrinking by one percentage point, to 27%, the overall pie continues to expand rapidly.

Unfortunately, the EIA also predicts that the increasing use of fossil fuels will boost the amount of carbon dioxide produced 46% by 2040. Burning coal throws off twice as much CO2 as natural gas, so it's an obvious target for environmentalists and politicians looking for ways to trim greenhouse-gas emissions.

The Bottom Line

With the coal industry perking up as the price of natural gas rises, bulls on Peabody's shares see them rising by 50% to 100% in the next year.

President Barack Obama's goal is to cut greenhouse-gas emissions 17% by 2020 from 2005 levels. This summer, he directed the Environmental Protection Agency to create carbon-dioxide standards for new and existing power plants. His plan doesn't require congressional approval, but will likely trigger lawsuits.

The plan, if implemented in its initial form, could force the mothballing or modification of old coal plants and construction of new ones. But politicians are unlikely to risk jeopardizing a fuel that helps produce 40% of the nation's power supply.

The environmental issues "are a known problem, but I don't think any political party is going to shut down the coal industry," says JPMorgan's Bridges. He sees a continued gradual decline in the domestic use of coal, offset by an increase in exports of the fuel.

In sum, with low-cost domestic and international operations, Peabody could energize the portfolios of patient investors.

A Good Bet

With earnings and prospects on the rebound, Peabody looks like a long-term winner—particularly if it reduces debt, a goal of top management.